TÀI CHÍNH QUỐC TẾ 6 other exchange rate models

Assumptions • Perfect capital mobility and stable money demand • The country is small and open international prices and interest rates are given • In the long term the PPP holds • With e

VI Other Exchange Rate Models

1000 realizations of yt = c + yt + vt

−1

Stationary „white noise“ process

1 Monetary Approach to Exchange Rates

2 Portfolio Balance Approach to Exchange Rates

3 Conclusion

1 Monetary Approach to Exchange

Rates

Basic ideas:

Exchange rate between two currencies is determined by the

relative demand and supply of money in two countries

Assumptions

• Perfect capital mobility and stable money demand

• The country is small and open (international prices and

interest rates are given)

• In the long term the PPP holds

• With equal returns demestic and foreign assets

(securities) are perfect substitutes

• Investors are indifferent between investment in domestic

or foreign currency

• There is no risk premium for an investment in foreign

country and the uncovered interest rate parity holds

1 Monetary Approach to Exchange

Rates

Central Bank Behaviour

• The central bank controls the money supply (M) by

altering the monetary base (multiplier)

• The monetary base can be divided into national and

international components (domestic credit and

international reserves)

• The exchange rate is fully flexible

Implications

 If the domestic money supply (with constant domestic

price) rises above the output growth, the domestic

currency will depreciate

 A high inflation rate in foreign country and a high real

growth in domestic country would counteract this trend

1 Monetary Approach to Exchange

Rates

The flexible price model

The Dornbusch overshooting model

The interest rate differential by Frankel

The Dornbush Overshooting Model

Disadvantages of „the flexible price model“ does not

explain why exchange rat departures from PPP,

especially under the flexible exchange rate regime

because the assumption that prices of goods and

services change in short run → PPP holds in the short term

Dornbusch overshooting model (sticky price)

• How is the adjustment path of the exchange rate to the

new equilibrium after an exonenous shock

• Why exchange rates are so volatile

• Why exchange rates departure from PPP

• The strong correlation between nominal and real

exchange rats (EUR/USD)

The Dornbush Overshooting Model

Emprical Observations:

• In the short run PPP does not hold and the exchange rat

shows considerably more volatility than goods prices and inflation differentials would imply

• Prices of goods and services adjust very slowly (sticky

prices) Exchange rats and interest rates adjust fast

Assumption

• PPP and the quantity theory of money hold in the long

run

• Goods prices and wages are fixed in the short run

• Prices react to exogenous shocks with lags

• The covered interest rate hold at any time t (full

foresight)

• Expections are rational

The Dornbush Overshooting Model

Money Market Equilibrium

• Money supply = money demand: M=D

• Real money demand function: D/P=aY + bi (Y output, P

price level, i interest rate)

Short Run Adjustment to Monetary Expansion

• In the short run, output and prices are constant when

the money supply expands

• The interest rate has to decline in order to equal money

supply and money demand

• The exchange rate has to rise sharply (domestic

currency depreciate)

The Dornbush Overshooting Model

Long Run Adjustment to Monetary Expansion

• In the long run prices will rise and therefore nominal

interest rate rise as well

• With rising interest rates the exchange rate has to

decline (appreciation) to maintain the uncovered interest rate parity

• Therefore the exchange rate (e) „overshot“ its long term

level and only approaches its equilibrium in the long run

The Dornbush Overshooting Model

i o

P o

E o

t t t

t 0

t 1

2 Portfolio Balance Approach to

Exchange Rates (Branson 1977)

Basic idea

• The relative supply and demand in financial markets as

well as the relative conditions in money markets

determines exchange rates

• In contrast to the monetary exchange rate model,

investors have a preference for domestic investments and hold foreign assets only for a premium

• The approach is based on divercification of portfolios and

has a requirement that markets balance explains its

name, portfolio-balance approach

2 Portfolio Balance Approach to

Exchange Rates

Hence

• The uncovered interest rate parity holds only with a risk

premium

• The absolute change of net foreign assets is equal to

the current account balance of a country

• With flexible exchange rate the central bank does not

intervene in foreign exchange markets The current

account is equal to the capital account

• Because goods and services are considerably slower

than capital flows, variations of the capital account do not immediately result in adjustment of the current

account

t t

− 1

2 Portfolio Balance Approach to

Exchange Rates

Adjustment to Money Supply Shock

Short term adjustment (e.g the same day)

• If the interest rate declines in the domestic market

(expansion of the money supply), domestic agents want to hold more assets in the foreign markets

• This is not possible because the current account stays

unchanged in the short term (adjustment of production etc )

• The net foreign assets are constant in the short term as well

• The exchange rate has to adjust immediately to give an

incentive to hold more domestic assets

• The depreciation of the domestic currency makes foreign

assets more expensive and reduces the incentive to hold

2 Portfolio Balance Approach to

Exchange Rates

Long Term Adjustment

• In the long run the depreciation leads to a current

surplus and a capital account deficit

• The exchange rate converges to its original level

(appreciation)

• The adjustment process continues until agents hold the

desired level of foreign assets

3 Conclusion

1 Exchange rates are random processes, which are not

predictable Short term and long term volatility is very high

2 In the short term, PPP does not contain any explanatory

content

3 The monetary approach explains the exchange rat as

ratio between two money supplies

4 The overshooting solution result from the lagged

adjustment of goods prices to exogenous shocks

5 In the portfolio-balance approach the current account

surpluses are correlated with appreciation pressure